Madagascar - Industry and Trade Policy Adjustment Program Project

Docuncent or The World Bank FOR OFFICIAL USE ONLY f l --I - t Report No. P-4488-MAG REPORT AND RECOMMENDATION OF THE PRESIDENT OF THE INTERNATIONAL DEVELOPMENT ASSOCIATION TO THE EXECUTIVE DIRECTORS ON A PROPOSED DEVELOPMENT CREDIT IN AN AMOUNT OF SDR 12.5 MILLION AND A PROPOSED SPECIAL FACILITY FOR SUB-SAHARAN AFRICA CREDIT IN AN AMOUNT OF SDR 52.2 MILLION TO THE DEMOCRATIC REPUBLIC OF MADAGASCAR FOR AN INDUSTRY AND TRADE POLICY ADJUSTMENT PROGRAM June 5, 1987 Industrial Development and Finance Division Eastern and Southern Africa Projects Department This document has a restricted distribution and may be used by recipients only in the performance of their official duties. Its contents may not otherwise be disclosed without World Bank authorization.  DEMOCRATIC REPUBLIC OF MADAGASCAR CURRENCY EQUIVALENTS Unit = Malagasy Franc (FMG) US$ = 833 FMG (end May 1987) FISCAL YEAR January 1 - December 31 WEIGHTS AND MEASURES Metric System GLOSSARY OF ABBREVIATIONS APB = Professional Bankers' Association BCRM = Central Bank of Madagascar BFV = National Bank for Trade BNI = National Bank for Industry BTM = National Bank for Agriculture CcP = Postal Checking System CD = Certificate of Deposit CNE = Postal Savings System CNAPS = Social Security Fund CPI = Consumer Price Index DCL = Doubtful/Contentious Loans DRC = Domestic Resource Cost FNDE = National Fund for Development Expenditures FNI = National Investment Fund FNUP = Commodity Price Stabilization Fund IMI = Malagasy Institute for Innovation LIR Liberalized Import Rpgime MIEM = Ministry of Industry, Energy and Mining OGL = Open General Licence OMNIS = National Military Office for Strategic Industries PFP = Policy Framework Paper PIP = Public Investment Program SFA = Special Facility for Africa  FOR OFFICIAL USE ONLY CONTENTS Page No. Credit and Program Sunmary .a..* ................................ i i PART I - THE ECONOMY ...................... 1 Background *SIS*Pa*99aSeaaa@aagasaaaeaa*e. ga*a**........... 1 The Crisis Period ......... eggs. , 2 The Scabilization Period ..*.......... 3 Medium-Term Prospects ....... ... .................... 4 PART II - INDUSTRY, TRADE AND THE FINANCIAL SECTOR ............. 9 Industry and Trade ........ a...** a aa . a. a g g a a ........... . e..........aa g 9 Past Policy Environment ..S a a.....ag..........ag.gg.g.. gg ....... 10 The Financial Sector ..... ...a.... a a a ........ aaag.. ......aa.... a..a 11 Structure ................................. . *. a ............ 11 Performance . .......... ..................a.... 00G..6806800 13 Interest Rates ................... ........g.a.a.a.a.a.a.g.sag..........g 14 PART III - THE GOVERNM.ENT ADJUSTMENT PROGRAM ................... 15 The Adjustment Process .......... we ... 15 Macroeconomic Adjustment .................a. aa a aa.......... 15 Sectoral Adjustment ....................................... 16 Towards Accelerated Adjustment ...............................aa 18 Exchange Rate Regime ...Seasg.ag ggg. ag ..............gg g g g 19 Foreign Exchange Allocation and Import Liberalization ..... 20 Tariff Regime a ag ca........ ...agga S .agagg S. a a.. a.ag.......... ...... 22 Price Decontrol . ...... a aaa aagga aa a gg....................... 23 Public Investment Program ................................ 24 Public Enterprises .a.egagga. aagg.................... 24 Banking Sector a a a. .................. a ........................ 26 PART IV - THE PROPOSED CREDITS aa aaaa........... a a a a a a a a a a a a................aaa 27 Credit History ..aaaaaaaaaa.a a g.Ia g . aa.a.. .a.a....a... .. 27 Credit Objectives .......aa aaaaaaaaaaaaaaaaaaaaaaaa aaa............ a ....a.... a .a.a 28 Program Description ...a a. agae a. a a.a. aa........................a 29 Effects of the Adjustment Program ....................aa....a a.... 29 Prospects for the Economy without Adjustment .............. 29 Economic and Social Impact of Adjustment . .................. 33 Benefits and Risks aaagaaea aa........aaaaa ........................ 35 Procurement and Disbursement .......... aas 37 Tranche Release and Monitoring ...a a a............aeaa sa .. ..aaaa 37 Collaboration with the IMP ......agag..........................g..... 38 This document has a restricted distribution and may be used by recipients only in the performance of their official duties, Its contents may not otherwise be disclosed without World Bank authorization.  PART V - BANK GROUP STRATEGY AND OPERATIONS IN MADAGASCAR ...... 38 The Existing Portfolio *......... ........... .............. 38 Bank Strategy and Future Program .......................... 40 PART VI - RECOMMENDATION ..o .................. 41 ANNEXES: 1 - Economic Indicators ..................................... 42 2 - Status of Bank Group Operations ......... 46 3 - Supplementary Credit Data Sheet ..... .................... 48 4 - Government Statement of Industrial and Trade Policy oo... 50  MADAGASCAR INDUSTRY AND TRADE POLICY ADJUSTMENT CREDITS CREDIT AND PROGRAM SUMMARY Borrower: Democratic Republic of Madagascar Amount: US$100 million equivalent, of which: IDA, SDR 12.5 million (US$16 million); Special Facility for Africa, SDR 32.2 million (US$67 million); and 12 million riyals (US$3.2 million) from Saudi Arabia and 2 billion yen (US$13.8 million), of which 1 billion as a grant, from Japan under Special Joint Financing. Terms: Standard IDA terms. Credit Objectives and Description: The Credits aim at supporting policy reforms designed to increase the efficiency and productivity of the economy, reallocate resources to the more productive sectors, reorient these sectors towards exports and a greater use of domestic inputs, and stimulate the revival of the efficient segments of the industrial sector. This should increase the economy's capacity to generate foreign exchange and grow after years of contraction. Following a significant effort in the area of economic stabilization and some initial policy improvements at the sectoral level, the cornerstone of the proposed policy package is a major trade liberalization supported by exchange rate adjustment. The broadening of a market-oriented system for allocating foreign exchange would be accompanied by the removal of protective import prohibitions, rationalization of the import tariff structure and further price decontrol. The proposed policy package would also include measures in the areas of public investment, public enterprises and the banking system. The quick-disbursing proceeds of the Credits would increase the total amount of foreign exchange available to finance imports by all economic agents under a liberalized import regime, thereby supporting the movement towards a market- determined foreign exchange allocation system. Benefits: A liberalized import regime, together with an exchange rate level that reflects the supply and demand for foreign exchange, and a domestic price system substantially free from Government controls should ensure that the more efficient enterprises are able to expand their production levels and force the  - ii - less efficient firms to improve or suspend their operations. By raising. production levels of competitive firms and enhancing the profitability of exports, the proposed operation wculd contribute to Madagascar's economic recovery, provide employment opportunities to a growing labor force and help ease the balance of payments constraint. Reforms in public investment, public enterprises and in the banking sector would continue the process of achieving increased discipline in public sector management, while at the same time encouraging private sector initiative and imDroving the business environment. Risks: The main risk facing the proposed operation is that the Government's commitment to the continuing adjustment process may waiver under pressure from groups who are now benefiting from distortions. This risk is mitigated by several factors. First, the prolonged and serious difficulties of the economy and its bleak prospects without adjustment have helped to lay the foundations of a consensus on the need for sustained reform. Support for the proposed policies is growing in Government and private circles. Second, the Government has been implementing important and politically sensitive stabilization measures since 1981 and some sector reforms since 1984. It has, therefore, been building a credible record of gradual but cwntinuing reforms. Third, the expected benefits from an improved allocation of scarce resources and from increased imports that these Credits would entail can be expected to give tangible and timely credibility to the policy reform package. Fourth, the Credits' proceeds will be disbursed in three tranches, with release of each tranche linked to satisfactory implementation of agreed actions. Estimated Disbursements: US$ Million IDA FY 1988 1989 Annual 45 55 Cumulative 45 100 Appraisal Report: This is a combined President's and Staff Appraisal Report.  - 1 - INTERNATIONAL DEVELOPMENT ASSOCIATION REPORT AND RECOMMENDATION OF THE PRESIDENT TO THE EXECUTIVE DIRECTORS ON PROPOSED CREDITS TO THE DEMOCRATIC REPUBLIC OF MADAGASCAR FOR AN INDUSTRY AND TRADE POLICY ADJUSTMENT PROGRAM 1.01 I submit the following report and recommendation on a proposed IDA Credit of SDR 12.5 million (US$16 million equivalent) and a proposed Credit from the Special Facility for Sub-Saharan Africa of SDR 52.2 million (US$67 million equivalent) to the Democratic Republic of Madagascar on standard IDA terms, to help finance an industry and trade policy adjustment program. In addition, 12 million riyals from Saudi Arabia and 2 billion yen from Japan, of which 1 billion as a grant, would be provided under Special Joint Financing, bringing the total to US$100 million equivalent. Country data sheets are provided in Annex 1 to this report. PART I - THE ECONOMY 1.02 A report entitled "Current Economic Situation and Prospects" (Report No. 5996-MAG) was distributed to the Executive Directors and to the participants in the Madagascar Consultative Group in March 1986. Its conclusions as well as more recent developments are reflected below. Background 1.03 With a population of ten million and a per capita income of US$265 in 1986, Madagascar is one of the poorest countries in the world. It is a large island, far from its trading partners, sparsely settled, with widely dispersed urban centers and a population density of about 17 inhabitants per square kilometer. While generally well endowed with natural resources and a variety of soils, the country has large regional variations in ecology and climate. The central plateau is the most economically advanced region, while the coastal areas, particularly in the south, are considerably poorer. Agriculture is the mainstay of the economy, accounting for two fifths of GDP, providing employment for over four fifths of the population, and generating about four fifths of export earnings (coffee, vanilla, and cloves). 1.04 For about a decade following independence in 1960, Madagascar's economy grew at an average annual rate of three percent. The years following 1972 marked a turning point in the country's political and economic development. The Government which took office in 1972 emphasized state control of the economy. It introduced inward-looking policies aiming at self-sufficiency in industry and agriculture, nationalized most of the larger private companies, adopted interventionist practices characterized by price controls and administrative regulations, and established direct or indirect state control over the greater part of agriculture marketing. The  - 2 - present Government, which came to power in 1975, intensified, extended, and codified these policies. Real GDP rose at an annual rate of only one half of one percent between 1970 and 1978 as agricultural output stagnated and Madagascar, which had been self-sufficient in food and a net exporter of rice, became a heavy importer of rice, the main staple. 1.05 Through 1977, fiscal and balance of payments policies remained cautious, and public external debt was kept at a low level. Starting in 1978, in the face of stagnating economic activity, the Government attempted to diversify the economy, and adopted a policy of "all-out investment" by the public sector with greatly increased reliance for its financing on external sources. The share of investment, mostly public, to GDP rose sharply to about 25 percent in 1979 and 1980, while the heavy resort to foreign financing resulted in a four-fold increase in Madagascar's external debt between 1978 and 1980. Many of the projects selected were economically and financially unviable; they therefore made little contribution to GDP, exports or debt servicing capacity. As a result, by 1980, the debt service ratio was rising sharply. Domestic economic policies were also geared towards expansion: the overall fiscal deficit, which had averaged 2.5 percent of GDP between 1970 and 1978, surged to over 18 percent in 1980, and the inflation rate reached 30 percent per year. The Crisis Period 1.06 The financial crisis that started in 1980 was the result both of inappropriate policies and of external shocks. As Madagascar's export prices remained sluggish and international oil prices doubled, GDP and the volume of exports continued to decline; external debt service obligations (before rescheduling) relative to exports escalated from about four percent in 1978 to about 72 percent in 1982, and the current account deficit of the balance of payments reached 18 percent of GDP. As resource constraints tightened, domestic investment plummeted. Under the impact of heavy external payment obligations, declining export earnings, and reduced creditworthiness, severe foreign exchange shortages prevailed. To prevent a run on reserves, the Government increased quantitative restrictions on imports while the exchange rate remained linked to the French franc until 1982, when it was pegged to a basket of currencies of major trading partners. Import constraints, the severe rationing of foreign exchange and an overvalued exchange rate contributed to a sustained decline in industrial and agricultural production. 1.07 By 1982, real per capita GDP had fallen by an estimated 28 percent from its 1973 level. Major factors contributing to this decline were: (a) the persistent climate of uncertainty within the private sector created by the nationalizations of the mid-1970s, combined with the rapid expansion of an inefficient and unmanageable public sector resulting from takeovers and new ventures; (b) excessive market regulation, through price fixing and controls which favored urban consumers, restrictive licencing legislation, quantitative import restrictions and exchange controls, and the establishment of national and regional marketing monopolies (for cereals, agriculturs